Sterling and

An important factor behind the significant reduction in the rate of UK price inflation has been the rise in sterling. By mid-August, however, sterling had depreciated from its peak against the US dollar by over 25% and fram its effective rate peak by over 10%. (1) This note discusses the resulting upward pressure on UK prices. It disputes the view that sterling's movement against the dollar gives a better indication of the inflation effect than the movements in its effective . The response of wages is very uncertain. This note suggests that, in the absence of any wage response, consumer prices could rise on account of depreciation by only one quarter of the fall in the effective rate after two years.

The relevance of the effective rate Table A Sterling has depreciated heavily against the dollar but by Exchange rate weights

comparatively little against currencies in the European Import shares Effective rate index(a) index(a) Monetary System. It has been argued that the United ----- Kingdom has thus had the worst of both worlds: the Austria 0.81 1.00 Belgium 6.85 4.04 maximum inflation effect (because-so the argument Canada 3.73 1.51 Denmark 2.91 1.09 runs-UK import prices, especially of primary products, France 10.29 10.39 West Germany 15.05 14.08 are set in dollars) but with little gain in competitiveness Italy 6.10 7.18 (because the most important markets are in Europe). In Japan 4.52 13.67 Netherlands 8.99 4.80 particular, it has been suggested that the change in the Norway 3.80 2.11 Sweden 3.90 3.73 effective rate understates the impact of recent exchange rate Switzerland 6.90 3.00 changes onUK import prices, and thus on UK inflation, United States 15.95 24.63 Australia 1.28 1.99 because the dollar has a weight of only one quarter in the Finland 2.09 0.85 Ireland 4.71 4.05 sterling effective rate index. Spain 2.12 1.86

(8) Based on share by value in 1980 (overseas trade statistics basis). As presently constructed, the sterling effective exchange rate index is geared to the trade balance effects of exchange rate movements: given a particular set of exchange rate index (see the second column in the table); and in fact the changes against sterling, the index shows that uniform US dollar has a considerably smaller weight in the 'import movement in sterling against all the currencies in the basket shares' index than in the effective index. which would have an equivalent impact on the trade Chart A compares the indices derived using these two sets ) balanceY Though in principle there is no reason why the of weights.The 'import shares' index has recently fallen effective exchange rate should be suitable as an index slightly less fast than the effective rate, so an index measuring the inflationary impact of exchange rate constructed in this way would attach less significance to changes, the weight given to the dollar does not in fact recent exchange rate developments than the effective rate appear to be too low for this purpose. Those who believe index (and, of course, still less than the sterling/dollar rate that the dollar should be given a greater weight than in the alone); this is mainly because of the lower weight given to effective index have made the following points. the dollar in the 'import shares' index.

Weights reflectingthe shares of countries in UK imports may Effectiverate weights understate the importance of the be more appropriate for an index directed towards the price dollar, because some UK imports from countries other than effects in this country of exchange rate changes. (3) the United States may also be invoiced in dollars. Table A shows weights based on shares inUK visible The evidence on invoicing ofUK imports is limited. The imports for the countries included in the effective rate results of surveys of currency invoicing ofUK imports 5 index.(4) Except for theUnited States and Japan, the conducted in 1978 and 1979 by the Department ofTrade( ) weights are broadly similar to those of the effective rate suggest that roughly 40% ofUK imports are invoiced in

(1) Quarterly averages of these rates are shown in Chart A. Sterling reached its recent peak against the US dollar (12.4650) on 24 October 1980 and in effective terms (105.6) on 28 January 1981. Its construction and the weights used in its calculation were described in the March 1981 Bullelin, page 69. AS Table A (2) . , . shows, the weight of the US dollar in the effective rate index is considerably greater than our lIateral trade with the � .Unlt.ed States would suggest. This largely reflects the importance, for the UK trade balance, of the United States as a competitor In third markets. (3) This assumes that exporters price in/their own currencies without reference to exchange rates. (4) The only sizable omission in terms of import share is Saudi Arabia, though several countries have a larger import share than Austria (the country with the lowest weight in the index). (5) The most recent of these. carried out on imports in October 1979, was reported in British Business, 13 February 198 J, page 318.

365 Quarterly Bulletin: September 1981

Chart A weight to the dollar, and that the price implications of the Exchange rate indices(·) recent strength of the dollar are understated by the sterling 197 = 100 Logarithmic scale 5 effective rate index. - 110

Although a full analysis of the interaction between primary product prices and flexible exchange rates is beyond the / scope of this note, an examination of the correlation Sterling I " ! - 100 doU.r I', between aggregate primary product price indices rate \ I denominated in different currencies and the relevant I exchange rates may provide some insight.(I) For this I purpose the dollar and the SDR(2)have been used; if, for - 90 example, a basket of currencies, such as the SDR, is less likely to distort 'true' commodity prices (in other words, if SDR-denominated prices reflect underlying market conditions better than dollar-denominated prices) then movements in the SDR/dollar exchange rate will be more - 80 closely related to movements in the dollar-denominated series than to those expressed in SDRs.

The results obtained from relating changes in aggregate primary product price indices (denominated alternatively in 1111111111111111111111111111 dollars and SDRs) to changes in the SDR/dollar exchange 1975 1977 1979 1981 rate are given in Table B. The indices for metal ores and (a) Quarterly averages except 1981 Q3 which is July and August. agricultural raw materials appear to be less sensitive to exchange rate movements when expressed in dollars­ sterling, 30% in dollars and 30% in other currencies. The perhaps reflecting the high proportion of dollar­ share of imports invoiced in dollars is therefore only slightly denominated producer pricing-but this result is reversed greater than the weight of the dollar in the effective rate in favour of the SDR once metals and food are included. index. Furthermore, the currency of invoice is probably only of short-run importance. Over time, prices quoted in TableB dollars will adjust in response to movements in exchange Correlation of monthly percentage changes in the rates: for example, quoted dollar prices may tend to fall SDR/dollar exchange rate and commodity price indices (1976-80) following a general strengthening of the dollar, because third countries will still be able to maintain their previous Denominated in: receipts in terms of their own currencies even if they quote Dollars SDRs lower dollar prices; in addition, demand may weaken if Metal ores -0.185 +0.338(.) dollar prices are not reduced. Thus the invoicing evidence Metals -0.377(0) +0.215 Agricultural non-foods -0.276(0) +0.316(.) does not suggest that changes in the sterling/dollar Foods -0.601(0) +0.025 All items -0.632(0) +0.224 exchange rate should be given any more significance in considering its impact onUK domestic prices than is (a) Significont at the 95% level. already reflected in sterling's effective rate. The results for the foods index are particularly striking, reflecting the importance of products covered by the Primary product prices are particularly important to the Common Agricultural Policy (CAP) of the European , because of their impact on the prices of Community inUK imports. The 'all items' dollar index domestically produced goods. shows a strong tendency to move inversely with changes The importance of theUnited States in the production, in the international value of the dollar, while the consumption and marketing of many internationally traded corresponding SDR index is not significantlycorrelated commodities has made the dollar an obvious numeraire for with the SDR/dollar rate. In addition, the SDR series are a large proportion of trading on commodity markets­ generally more stable: their coefficients of variation are though in so far as it affectsUK import prices this will be smaller than for the dollar indices, even after allowance for reflected in the invoicing data discussed above. But the US trends in the series, and they are not sensitive to exchange dollar prices have also become accepted in some quarters as rate fluctuations. providing a 'true' measure of primary product prices, in the sense that fluctuations in dollar exchange rates are This suggests that the sterling price paid by British industry transmitted-with due allowance for invoicing lags-into for raw materials depends upon sterling's rate against the prices paid in local currencies by other countries. Again, currencies in general, and not just against the dollar. this could mean that the effective rate gives insufficient Indeed, the results obtained from relating percentage

(I) These indices comprise market price quotes, so trade invoicing considerations and contractual lags are not relevant here. The individual prices are, however, weighted according to the importance of the primary products in UK imports because the argument is being examined in the UK context. (2) The valuation of the SDR was described in the MaTch 1981 Bulletin, page 66.

366 Sterlingand inflation

changes in industry's wholesale buying prices for raw higher wages because domestic production will have materials (including oil) to exchange rate movements are become more profitable. How quickly and by how much consistent with the result that the importance of the wages increase are crucial to the longer-term price effects, sterling/dollar exchange rate in the determination of because any rise in wages could influence wholesale and sterling commodity prices is in turn dependent upon the consumer prices and initiate a further rise in wages.(3) close association between this rate and sterling's effective rate. When the sterling/dollar rate was split into In order to cut through the complexities it is helpful to components reflecting separately the overall strength of the consider the results of a simulated exchange rate dollar and of sterling, then it was only the latter which depreciation using the Bank's short-term model. Chart B shows any significant degree of association. (I) shows the simulated effects.of a 10% sterling depreciation against all currencies which is not subsequently reversed, The impact on prices and wages of a lower exchange rate A lower sterling exchange rate against currencies in general ChartB will influenceprices and wages in numerous interrelated Price impact of 10% depreciation(a) Cumulative change(b) ways, the full effect of which will only come through after Per cent 12 some time. The immediate effect is most strongly felt on Imported fuels import prices. Within three months the sterling cost of ,..------. I Imported industrial imported industrial materials will probably be raised by materials ...... 10 r • ..... • • . nearly the full amount of the depreciation, as will the • r • • • • .• • sterling cost of imported fuels and home-produced oil. r • • • Imported food prices will rise by rather less because, unless r •• /· � the 'green pound' is changed, the prices of foodstuffs 1 Im ed fooda ----= .. covered by the CAP will be unaffectedby a depreciation of I: I: sterling. Finished goods prices also rise by less than the full ------r: / Importedfinished goods . extent of the depreciation: these are influencedin part by I· " I UK domestic prices,(2) whose response to depreciation is I I much slower-though as it grows over time these import I I r prices will continue to rise. I I I I The increase in the sterling cost of imported raw materials I will raise manfacturers' costs; thus wholesale prices will I rise, possibly by more than the share of imported materials I I in costs would suggest, because internationalcompetitive

restraints on output prices will have been eased by Quarters foHowing the depreciation depreciation. The strength of this response may well be (a) From the Bank', short-term model, assuming DO wage influenced by demand conditions. For example, the present response.The exchange rate is usumed to remain 10% below the level it would otherwise have been. weak state of demand at home and abroad may mean that (b) A l0C7o depreciation of sterUng against the dollar is equivalent to an increase of 11.1% in units of sterling per dollar. As it is companies may not be able to pass on automatically the the latter fate which is relevant in this context, the 10% depreciation leads eventually to a rise slightly greater than higher cost of imported materials. In addition, some 11,"0 in some import prices. materials (such as oil) will have a greater influenceon costs than their import weight suggests because a proportion of manufacturers' requirements is met by domestic and assumes that nominal wages are unaffected by the ) production. depreciation. (4 Wholesale and consumer price responses are relatively muted: after two years, consumer prices have There are, however, further repercussions. The rise in risen by only one quarter of the fall in the exchange rate. wholesale selling prices will feed through to consumer prices, which will also be influenced directly by the rise in Any response of wages would tend to increase wholesale the price of imported consumer goods. Wages may also be and consumer prices further-in the long run by the full affected. Employees may attempt to offsetthe erosion of extent of the depreciation if wages rose by a similar (5) real incomes brought about by the rise in consumer prices; amount. Present labour market conditions, and the low in addition, employers may be more prepared to concede level of profitability in the manufacturing sector, may

(I) Correlations between monthly percentage changes in UK industry'S wholesale buying prices for raw materials (denominated in sterling) and changes in various exchange rates between 1916-80 are: Sterling/dollar rate -0.556 Dollar effective rate + 0.120 Sterling effective rate -0.629 (2) Recent Bank research suggests a figure of around 30%: see I D Bond, The determination 0/ UK manufactured import prices, Bank of England Discussion Paper No. 16. (3) For a more detailed exposition see R N Brown, C A Enoch and P D Mortimer·Lee, The interrelationships between costs and prices in the United Kingdom, Bank of England Discussion Paper No. 8. (4) The 'green pound' is also assumed t6 be unaffected by the depreciation. (5) If wages rise in line with consumer prices (but do not anticipate any price rise) consumer prices rise by one third of the exchange rate depreciation after two years.

367 Bank of England Quarterly Bulletin: September 1981

moderate the wage response; in any circumstances, the final outcome will depend on the strength of monetary and fiscal policy. Because of the various lags noted above, not all the benefits of the appreciation in sterling over 1979 and 1980 will have come through to consumer prices yet; thus any upward pressure on consumer prices arising from the recent depreciation should for some time be at least partially offset by the delayed effects of the earlier appreciation.

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